FINANCIAL MARKETS’ ASSESSMENT: Term structure-based EMU 6


While the objective of proxying for global trends in credit markets is laudable, the diagnostics of model performance in- and out-of-sample overstate the model’s reliability. The major difficulty is that the independent and dependent variables, while stationary, are highly persistent. The high reported R2’s (ranging from 61% to 83% on 1300 daily observations over 1988-92) are therefore to be expected, while good out-of-sample forecasting performance over 1993 is also to be expected for highly persistent variables. Dickey-Fuller tests for stationarity of in-sample residuals are also run — the standard Engle-Granger test for cointegrated variables — but since the variables are stationary the relevance of this test is not apparent.

It does appear that the global variables used in assessing Morgan’s non-EMU scenario contain some information for post-1992 swap spreads. In particular, several countries experienced temporary declines in swap spreads relative to Germany over 1992-94, and again after 1995 (see Figure 3) that are in part correlated with Morgan s estimated non-EMU swap spreads.14 Overall, the regression approach appears somewhat preferable to just using average spreads over some interval as an estimate of the non-EMU scenario.15 Nevertheless, it must be recognized that the non-EMU estimate potentially contains considerable structural instabilities that could affect EMU probability inferences. People need payday loans like speedy cash because they all need money at some point. If you arrived at this point, you probably need a loan with low APR and fair terms that you can be sure about. You are welcome to visit website to get a loan like this, and we can guarantee you will not be sorry about this decision.
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FINANCIAL MARKETS’ ASSESSMENT: Term structure-based EMU 5

A further potential bias originates in numeraire issues when considering the forward expectations hypotheses underlying EMU probability calculators. The “risk-neutral” expectational operators that incorporate the assorted risk premia by changing the probability measure do depend upon which currency is used when assessing investments. Consequently, forward rates from Italian and German swap rates cannot be compared without first expressing the underlying investments in a common currency.
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where Et is the risk-adjusted expectations operator relevant to the domestic investor when assessing future speculations, given the domestic discount factor used in (15). From (5) above, ftT 9 E**(rt+T). However, the same is not true for the relationship between the foreign forward interest rate and future spot rate from the domestic investor’s perspective. The zero-profit equilibrium condition on contracting to borrow foreign currency at the forward interest rate and subsequently investing at the spot interest rate is
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FINANCIAL MARKETS’ ASSESSMENT: Term structure-based EMU 4

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Whether European Monetary Union will have real economic effects, and of what sign, has been a matter of considerable debate. Bean (1992), for instance, argued that both the long-term costs and the long-term benefits are likely to be small, implying little divergence between actual and risk-neutral probabilities. On the other hand, the short-term consequences for economic policies and interest rates of failing to achieve membership in a currency union could in principle be substantial.

For instance, a failure by Italy to achieve either the interest rate or inflation criteria of the Maastricht treaty might well have caused yet tighter monetary policy, in order to qualify at a later date. Whether this matters for risk premia does, however, depend upon the degree to which Italian bond markets are segmented from world markets. It appears appropriate to interpret inferred probabilities as “risk-neutral” probabilities and, to a first approximation, as conditional probabilities as well. Getting fast easy payday loans online has never been easier. Visit us at review to get your money without waiting. No matter what you need – to pay off your credit card debt, buy something urgently or achieve any other financial goal: we can guarantee best interest rates and easy application.
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FINANCIAL MARKETS’ ASSESSMENT: Term structure-based EMU 3

EMU probability calculators are useless if European term structures contain little information regarding future interest rate changes. However, as discussed in Gerlach and Smets (1997a,b), Hardouvelis (1994), and Bekaert, Hodrick and Marshall (1997), European term structures tend to
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for n-month Eurodeposit rates Rtn (n = 3, 6) relative to the forward rates Finferred from n-month and 2n-month Eurodeposit rates. Short-maturity forward rates are definitely informative with regard to future short-term rates, but the unbiasedness hypothesis is rejected for about half of the countries. Table 1B shows that intra-European forward spreads relative to the German forward rates do even better when forecasting of future interest rate differentials, with only 3 regressions out of 18 rejecting the unbiasedness hypothesis. there

As discussed in Gerlach and Smets (1997a,b), part of this greater consistency with the expectations hypothesis is undoubtedly attributable to the greater past predictability of European interest rate changes. Speculative attacks on the weaker currencies participating in the European Monetary System generate temporarily high short-term interest rates for those currencies, and sharply inverted term structures that correctly predict future interest rate declines once the currency is devalued.10 The expectations hypothesis fares less well for the DM, pound, and dollar, which were typically less constrained by exchange rate targets over 1977-98.
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